We've Expanded!

Unlike the U.S. Economy during the duration of this blog, our operation has just undergone a substantial expansion. Please visit us at www.whiteanalytics.com  for news, commentary, a whole host of spreadsheet models and all your favorite FRED Data Transformations.

Meanwhile, this blog will revert to what it once was, a less serious and tedious platform that isn't shy about posting Gary Larson and bad puns, as well as economics.

Self-Indulgent Argument Time: Leverage is a Feature, Not a Bug

Time to pay homage to this blog's silly title and go on a bit of a rant. I'm going to voice what on the face of itself may appear to be an absurd, reactionary promulgation, but here goes: Limits on financial leverage imposed on banks are counter-productive.

In fact, not only have I concluded that limits on leverage are wrong, I'll go one step further: I'm willing to postulate that nine out of every ten people in favor of strict leverage limits haven't really thought through the dynamics of their position, or perhaps are a bit unclear of the parameters of the issue entirely.

Here's the reason why. When all is said and done, "financial intermediation" and "leverage" are actually the same thing. Synonymous. By-words for each other. When a bank accepts a dollar in deposit from a customer and lends $0.90 of it out (keeping $0.10 on reserve at the Fed of course), that increases the bank's leverage, because it has issued a liability in the form of the deposit and acquired an asset with the proceeds in the form of the loan + the reserve it now claims on the Fed. If this leverage- and- risk- multiplying transaction sounds suspiciously like old fashioned "banking," its because it is. Banks borrow funds from net creditors and lend them to net debtors, pocketing the spread between interest paid to the creditors and that charged to the debtors.

Pundits and commentators eager to reign in the "big banks" and Wall Street in general often portray the phenomena of leverage in a far more exotic form, as if it were a fundamentally unsound and dangerous proposition. In the parlance of the cognoscenti, banks "gamble with borrowed money," which is actually the same thing as lending out deposits.

As Alan Greenspan wrote in the memoirs, when considering the implication of an argument, it can help clarify the point if one carries the argument to its logical extreme and see if it makes sense. If the answer to financial stability is strict limits on bank leverage, why not ban leverage entirely? Wealthy shareholders could get together and pool their money into capital funds, and lend it out to borrowers, while accepting no deposits from the common sort of people who presently use banks and thus increase those bank's leverage. The rest of us could resort to stuffing our life savings under the mattress, or bury it in the desert and hope no one finds out. Come to think of it, it makes me wonder if the whole financial regulation movement hasn't been secretly underwritten by the safe manufacturing industry from the very start.

Crimea, Putin, and the End of Economic Unilateralism

The specter of American decline has loomed large in the imaginations of the talking heads in the media and in politicians who offer purported solutions to avoid calamity. We hear about unfair Chinese trade practices hollowing out American industry, the test scores of students in South Korea and Finland relative to our own, or the inevitable collapse of the dollar as its value strains under the weight of our perennial current account deficits.

While most of this has is genesis in hype and speculation, one fact cannot go unacknowledged: the economic hegemony of the United States, and the resulting ability of U.S. policymakers to wield near omnipotent power of foreign governments and institutions, is at an end. This new state of affairs is made painfully evident by the ease of which Vladimir Putin has walked into Crimea and conducted an effective annexation, despite clear objections from Washington, and Brussels to boot.

The reason Mr. Putin has (correctly) calculated that he can get away with this hitherto unthinkable maneuver is simple: He's got the economic muscle to back it up. While Russia's economy may have many critical structural weaknesses that preclude its workers from enjoying standards of living on par with those in Western Europe and North America, it does pull in hundreds of billions of dollars per annum in the form of natural gas and crude oil exports. As a result, Russia has accrued in the neighborhood of $500 billion in foreign exchange reserves, to which is adds every year by dint of its secular current account surplus. This war chest gives the Kremlin the confidence and ability to literally march to its own tune, secure in the knowledge that it can pay its bills regardless of ire it may cause on Capitol Hill. And with demand for fossil fuels ever increasing from developing economies, don't count on this windfall to dry up on any foreseeable time horizon.

The point of all this is not that the primacy of the United States is over, but rather that Washington must accustom itself to playing more of a "first among equals" role on the international political stage. The alternative is for future U.S. Presidents and policymakers to make bold proclamations and draw lines in the sand- lines over which our competitors will be increasingly non-hesitant to march.

Asset Markets See the Light: No Fed Taper on the (near) Horizon

It seems that financial asset markets have lost the jitters they've been feeling for the last several weeks based on the misguided fear of an imminent Fed "taper." The jobs report which came out today had unemployment at 7%, a half a percentage point above the metric Bernanke laid out as a parameter for the current bond-buying regimen of $85 billion per month. This return to complacency following the recent hand- wringing means one of two things: either I'm highly influential and my message has gotten through, or bond and equities traders have actually decided to take the explicit policy pronouncements of the FOMC at face value. I know which option I'd like to believe.

Like I've said, short-term interest rates are going to stay low as long as unemployment remains above at least 6.5%. Bond investors have nothing to fear but a strong labor market. When the FOMC meets on Dec. 18, lets hope they give me an early Christmas present in the form of a vindicated prognostication.

Sumner, Krugman, Williamson, and My Two Cents

There's been a recent row in the economics blogosphere over the nature of quantitative easing, and its long-term effects on the price level. FOMC member John Williamson recently implied that quantitative easing, instead of causing inflation, instead will exert deflationary pressures on the economy in the long-run. Here's a quote: "The Fed is stuck. It is committed to a future path for policy, and going back on that policy would require that people at the top absorb some new ideas, and maybe eat some crow. Not likely to happen. The observation of continued low, or falling, inflation will only confirm the Fed's belief that it is not doing enough, not committed to doing that for a long enough time, or not being convincing enough."

Paul Krugman, Scott Sumner, and Nick Rowe, among others, have already jumped into the fray, with predictably intriguing discourse ensuing. 

Here's my two cents: Williamson mixed up the difference between real and nominal. Its really as simple as that. Quantitative easing, i.e. dramatically increasing the supply of base money in an economy, doesn't by definition induce asset owners to increase their real holdings of money, i.e. a great amount of purchasing power over goods and services in the form of currency or demand deposits; it by definition induces them to increase holdings of nominal balances.

Lets investigate this using some preliminary algebra. The real money supply is equal to the nominal money supply divided by the price level so that we write:

mD = MS/P

This means the real purchasing power of the money supply is equal to total amount of base dollars in the economy, i.e. paper money plus bank reserves at the Fed, divided by the price level, which is the "average" price of all output in the economy. Quantitative easing means an increase in the nominal money supply, the MS term in the above equation. Williamson has in effect postulated that for an increase in MS, mD must rise by the same amount, which implies that P must correspondingly fall to maintain the equality. What he overlooked is that just because a central bank decides to increase the supply of nominal money, asset holders do not necessarily want to hold more purchasing power in the form of money base. Instead, it is the level of prices that rises via inflation so that the newly issued money is held as real balances to keep purchasing power constant.

Memo to Skittish Bond Holders: Remember the Dual Mandate

The Federal Open Market Committee is not going to "taper," or slow the rate of its bond-purchases, in the short or medium term. The Federal Reserve Act ultimately governs the policy goals of the FOMC, and the Act contains a dual mandate to "maintain long run growth of the monetary and credit aggregates .... so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

Under Bernanke's leadership, the Committee has made an explicit commitment to maintain the bond-purchases of $85 billion per month until unemployment falls below 6.5% or inflation rises above 2.5%. Unemployment is currently running at 7.3% while headline inflation is approximating 1%.

Even the 7.3% unemployment rate is a misleading indicator of conditions in the labor market. Only Americans who are actively seeking employment are counted- the official number excludes those who have become discouraged and dropped out of the labor force due to lack of job opportunities. A more representative measure of the condition of the labor market is the civilian employment - population ratio, which peaked at 63.3% in the third quarter of fiscal year 2007 but which was 58.3% in October.

The current population of the United States is 313.9 million. If the same proportion of the population was employed today as in the third quarter of 2007, it would take the creation of another 15.695 million jobs; with that kind of employment gap and inflation average less than 1%, securities markets shouldn't expect a hike in rates nor a "taper" in quantitative easing in the near future.

Bond Markets and the Ever Elusive Taper

Bond market watchers have, in recent weeks, become mindful of what is widely perceived to be an possible game changer: If the Federal Reserve, as expected, announces an exit strategy from its $85 billion per month bond-purchasing program, known as QE3, investors can expect a rise in yields and a fall on bond prices, effectively ending the secular bull market in fixed-income securities that has prevailed since the inception of the Fed's zero-interest rate policy in December of 2008.

A concurrent and highly relevant development is notably absent from the recent discussion of the trajectory of the bond market: the imminent (it now seems) appointment of Janet Yellen as the new Federal Reserve chairmanwoman. Yellen's academic career as well as her previous contributions to the direction of monetary policy (she is the current Vice Chair at the Fed) indicate one thing for certain: her moral suasion as formal leader of of the Federal Open Market Committee will favor continued monetary expansion. As far as inflation "hawks" and "doves" are concerned, she is firmly the later. 

Continued expansion in the short-term is just what bond markets ought to expect regardless of changes in leadership. At the inception of QE3 in December of last year, Chairman Bernanke stated that the bond purchases would continue until inflation exceeded 2.5% or unemployment fell to 6.5%. Neither metric is near these parameters. The Federal Reserve, always wary of losing institutional credibility, is even more so in the last five years since its primary policy tool, adjusting the Federal funds rate, has failed to return the economy to full employment. Reneging on an explicit policy pronouncement is unlikely to be on the Fed's agenda.

On a longer time spectrum, and with the assumption that Yellen's tenure will result in a continued expansionary stance for monetary policy, longer-term bond yields are actually as likely to rise as to fall. If unemployment remains high and the economy continues to operate below potential, the "liquidity effect" caused by swapping monetary base for interest-bearing Treasury bonds will hold rates down all along the yield curve. If, on the other hand, a consistently expansionary stance of policy actually succeeds in boosting demand, creating jobs, and moving the economy toward full employment, inflation expectations will rise. At this stage the "Fisher Effect" will dominate, and nominal interest rates will rise as investors demand a premium to protect their real yield from erosion by inflation. In short, bond investors won't feel the heat unless it's generated by the labor market.